Chapter 14: Relationship between returns on asset classes Flashcards
What is the formula for both the required return and the expected return of an asset?
❖ Required return= required risk-free real return + expected inflation + risk premium
❖ Expected return= initial income yield + expected capital growth
❖ Expected return ≈ initial income yield+ income growth+ impact of a change in yield
What does it mean if the required return = the expected return?
❖ Assets are fairly priced
What does it mean if the required return for an investor is less than the expected return?
❖ The Assets appear cheap for that investor
What is the expected return for the following?
Equities, Conventional government bonds, Index-linked bonds, Property , cash
1> Equities
– Dividend yield+ E [Nominal dividend growth]
2> Conventional government bonds
- GRY(Nominal) - gross redemption yield
3> Index-linked bonds
- GRY(Real)
4> Property
- Rental yield+ expected nominal rental growth
5> Cash
- Short-term nominal interest rates
Over the long term, what is the equity dividend growth expected to be close to?
❖ Economic growth=> GDP
i. Assumes share of GDP represented by ‘capital’ remains constant over time
❖ Dilution effect=> Companies raise new capital - new issues of shares in an existing company
i. Extent to which economic growth is generated by start up companies
When will the real returns on conventional bonds be poor?
❖ Inflation turns out to be greater than expected
❖ Period where yields are rising=> Price of real bonds decrease=> real return is lower
What factors affect the expected return on cash?
❖ Return on cash=> Expected to exceed inflation
i. Except in periods where inflation is rising rapidly
❖ Short term real interest rates can also be kept very high or very low by governments for significant periods of time
Over the long term what are wages expected to grow in line with?
❖ GDP=> economic growth
